FIDM 2019-20 - L4 Complete

BM01AFM
Financial Information &

Decision Making
Lecture 4: Decision making
RSM – 2019-20
PAC
PAC
• Daan van Rooijen
• Cas Beije
• Jessica van der Vlugt
• Judith Zonder
• Alexander Laan
• Marjoleine Maas
RSM – 2019-20 2
Recap • Relevant/opportunity costs • One time order / outsourcing • Cap. constraints • Pricing
From Understanding Costs to Decision Making
Decision
making
Cost allocation Opportunity cost

What resources are Is there an
required by Cost behavior alternative use for
products, customers, the required
projects, …? Do cash costs of resources?
these resources
change with the
decision we take?
RSM – 2019-20
To Evaluate Alternative Courses of Action, We Need to Know:
Relevant costs and revenues are those that
• Differ between alternative courses of action and
• Affect future cash flows
Already incurred costs are “sunk” and thus irrelevant
RSM – 2019-20
The sunk cost fallacy
• “I might as well keep eating because I already bought the food.”

• “I might as well keep watching this terrible movie because I’ve watched
an hour of it already.”
• “I might as well keep going to a bad/useless class that I paid for/got up at
8am for.”
RSM – 2019-20 5
Opportunity Costs: University, a not completely serious example
Choose two
Sleep
University
Good
Party
grades
RSM – 2019-20 6
Opportunity Costs: University, a more serious example
Continue working vs. getting an MBA

• MBA program opportunity cost: loss of current salary
• Continue working opportunity cost: lower future salary potential
RSM – 2019-20 7
Identifying Relevant Costs is Context-Specific
What’s relevant and what’s not differs across decision problems
‒ One time order / special pricing
‒ Outsourcing (make or buy) decisions
‒ Product-mix with capacity constraint(s)
‒ …
RSM – 2019-20
Relevant information in a firm context
Excess capacity or not?

• If capacity is constrained, producing one type of product means not
producing another type of product ( OC)
Are costs avoidable or unavoidable?
• Many fixed costs are continued to be incurred, e.g. even if production is
outsourced
Other qualitative or quantifiable non-financial factors?
• E.g., if we sell our product at a lower price to fill a one-time order, does
this have negative consequences for our pricing in the future?
RSM – 2019-20 9
One-time special order

Mountain Goat Cycles produces mountain bikes for $1500 each.
Production capacity is 4,000 unit per month and current production
is 3,000. Retail Inc. is not a regular customer of Mountain Goats.
They offer to buy a one-time order of 100 bikes for $1000 per bike.
Normal sale Special order sale

Sales price 1,500 1,000
Variable production costs 750 750
Fixed production costs 190
Fixed SG&A 100
Total costs 1,040
Profit/loss 460 250
Which costs are relevant? 750
Should Mountain Goat accept the offer?
RSM – 2019-20
Extreme Outsourcing at Volkswagen Resende, Brazil
Every production step is outsourced except for the final inspection (“Aprovacao Final”)!
RSM – 2019-20
Relevant Costs for Outsourcing Decisions

Mountain Goat Cycles produces 8,000 gear shifters per year for its
mountain bikes. Total costs are $21 each.
Another firm offers to supply shifters to Mountain Goat for $19
Make Shifters Buy Shifters

Outside purchase price 152,000
Variable production costs 120,000
Fixed production costs 6,000 6,000
Variable SG&A 2,000
Fixed SG&A 40,000 40,000
Total costs 168,000 198,000
Which costs are relevant? 122,000 152,000
Accept the offer?

RSM – 2019-20
Relevant Costs for Outsourcing Decisions
What if the capacity that we free up through outsourcing can be used to

produce race bikes with an incremental profit of $60,000 a year?
Make Shifters Buy Shifters

Outside purchase price 152,000
Variable production costs 120,000
Fixed production costs 6,000 6,000
Variable SG&A 2,000
Fixed SG&A 40,000 40,000
Opportunity cost:
Incremental profit race bikes 60,000
Which costs are relevant? 182,000 152,000
RSM – 2019-20
Relevant Information for Outsourcing Decisions
• Which costs differ between insourcing and outsourcing options?

‒ Avoidable costs in our own production
‒ Outside purchase price
‒ Incremental profit of next-best use of freed-up capacity if we outsource
• Other considerations in outsourcing decisions

‒ Lower quality control with outsourcing
‒ Deterioration in employee morale due to outsourcing
‒ Dependence on supplier
RSM – 2019-20
Dependence on supplier
Source: Financial Times RSM – 2019-20 15

Product Mix Decisions with Capacity Constraints
Source: Financial Times RSM – 2019-20 16

Product Mix Decisions with Capacity Constraint

Mountain Goat Cycles makes two saddles: Mountain and Touring.
Production requires the following two processes (among others):
• workers attaching foam to saddle (capacity: 560 labor hours)
• machine stitching the leather cover (capacity: 220 machine hours)
Mountain Touring
Demand 4,000 units 7,000 units
Selling price $25.00 $30.00
Total variable cost per unit $10.00 $18.00
Contribution Margin/unit $15.00 $12.00
Labor time required to attach foam (per unit) 3 min 3 min
Contribution Margin/labor minute $5.00 $4.00
Stitching machine time required (per unit) 2 min 1 min
Contribution Margin/machine minute $7.50 $12.00
How much of each product should MGC produce?
RSM – 2019-20 17
Manager must chose between two products and cannot produce both due
to capacity constraints:
Decision rule:
‒ Maximize production of the product with the highest contribution margin per
unit of the constraining resource (not the highest contribution margin per unit
of the product)!
‒ Once demand for that product is satisfied, produce as many units as

possible of the other product
RSM – 2019-20 18

• What is the constraining resource?
‒ Labor hours: 4,000 units * 3 min + 7,000 units * 3 min = 550h < 560h
‒ Machine hours: 4,000 units * 2 min + 7,000 units * 1 min = 250h > 220h
• Contribution Margin per unit of constrained resource (machine hours)

‒ Mountain: $7.5/min  $450/h
‒ Touring: $12/min  $720/h
• Decision
1. Make 7,000 units of Touring: 7,000 * 1 machine min = 116,6 machine hours
2. Make [(220h-116,6h)*60]/2min = 3,100 units of Mountain
• Total Contribution: 7,000 * $12 + 3,100 * $15 = $130,500
RSM – 2019-20 19
Market-based pricing
No/little differentiation among products

• Price is determined by supply and demand
• Cost-leader usually sets the price, little price-setting discretion to firms
• Fuel, milk, vegetables,…
RSM – 2019-20 20
Cost-based pricing
Firms determine costs to produce and sell product

• Identify and charge a reasonable markup
• Adjust the markup as needed in response to market forces
‒ Increase profits by setting an initially high price for those willing to pay, followed
by lower prices for the cost-conscious customer
 Full cost pricing
 Variable cost pricing
RSM – 2019-20 21
Full Cost Pricing: The Death Spiral
AEMO charged consumers

for fixed capacity costs
based on consumers’
energy consumption
Consumers’ consumption
decreased due to solar
energy
Network fixed costs

remained the same
Fixed costs spread over

smaller energy volume
Source: TheConversation.com RSM – 2019-20

Pricing at RyanAir
“We price
to fill the
plane!”
What are the relevant costs for adding one extra passenger?
RSM – 2019-20
Cost-based pricing
Firms determine costs to produce and sell the product

• Identify and charge a reasonable markup
• Adjust the markup as needed in response to market forces
‒ Increase profits by setting an initially high price for those willing to pay, followed
by lower prices for the cost-conscious customer
Full cost pricing

(+) Price must recover all costs in the long run and a normal profit margin
(-) Requires allocation of common fixed costs to individual product lines
(-) Allocating fixed costs per unit requires estimate of future sales  can lead to
cost over-/understatements
Variable cost pricing

(+) Does not require allocation of common fixed costs to individual product lines
(-) Managers may perceive variable costs as the ‘price floor’
(-) Fixed costs may be overlooked in pricing decisions, resulting in prices that are
too low to cover total costs
RSM – 2019-20 24
Pricing Decisions Without Cost Considerations
Martin Shkreli - MSMB Capital Management
RSM – 2019-20 •25

Pricing Decisions Without Cost Considerations
• Valeant’s business model: Buy R&D intensive pharmaceutical companies, close

down their R&D labs, jack up prices for protected drugs
• Costs are irrelevant for pricing decision
• Customers’ willingness to pay?
RSM – 2019-20
Generic Competition and Drug Prices
RSM – 2019-20 •27

Pricing Decisions and Target Costing
RSM – 2019-20
Pricing Decisions and Target Costing
• IKEA strives to minimize costs through “target costing”
• Target costing is the opposite of cost-plus pricing:

1. Determine price
2. Determine margin
3. Determine target cost (price – margin = target cost)
4. Adapt product design and production to stay within target cost
• Sum of relevant costs determines whether project is feasible
RSM – 2019-20
Committed vs. incurred costs
R&D and Design Manufacturing Marketing & Customer

Conception Distribution Service
100
Committed
Percent of
total costs
Incurred
Time
Choices early in the process (R&D + design) affect incurred costs later on
(manufacturing etc.), e.g. use compressed or solid wood for furniture?
RSM – 2019-20 30
Price discrimination
RSM – 2019-20 31
Leisure trip
RSM – 2019-20 32
Business trip
RSM – 2019-20 33
Price Elasticity of Demand
Degree to which consumers respond to price changes by buying more or

less of a product.
• Business travelers are less sensitive to price changes…

‒ less flexible, fly on company’s budget
• …compared to leisure travelers

‒ more flexible, fly on their own budget
• Companies can increase their profits by exploiting demand elasticity of

consumers
34
RSM – 2019-20
Questions?
See you next week!
RSM – 2019-20 35

To improve working conditions of the employees, the labor union “Goats
Unite” has initiated a strike at the production facility. 50% of the employees
have followed the strike. This has reduced the available labor hours to 280.
• What is the constraining resource?
‒ Labor hours: 4,000 units * 3 min + 7,000 units * 3 min = 550h
‒ Machine hours: 4,000 units * 2 min + 7,000 units * 1 min = 250h
• Contribution Margin per machine hour

‒ Mountain: $7.5/min  $450/h
• Contribution Margin per labor hour

‒ Mountain: $5/min  $300/h
RSM – 2019-20 36
Maximize C = 15M + 12T
Subject to
2M + T <= 13,200 (machine minutes constraint)
3M + 3T <= 16,800 (labor minutes constraint)
0 <= M <= 4,000 (non-negativity & max. demand M)
0 <= T <= 7,000 (non-negativity & max. demand T)
Rewrite as
M <= 6,600 – 0.5T
M <= 5,600 – T
0 <= M <= 4,000
0 <= T <= 7,000
RSM – 2019-20 37
8000
6600 Choose an arbitrary number to find the M & T equivalents

6000
and to calculate slope of function to be optimized, e.g.
5600 15,000 can be achieved by producing 1,000 M or 1,250 T
Max demand M
4000
A 1760 B
M <= 6,600 – 0.5 T
2000
M <= 5,600 – T
Max demand T
C = 15,000
1100 5600 13200
C
2000 4000 6000 8000 10000 12000 14000
RSM – 2019-20 T 38

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BM01AFM

Financial Information &

Lecture 4: Decision making

From Understanding Costs to Decision Making

Cost allocation Opportunity cost

To Evaluate Alternative Courses of Action, We Need to Know:

Relevant costs and revenues are those that

• Differ between alternative courses of action and

• Affect future cash flows

Already incurred costs are “sunk” and thus irrelevant

The sunk cost fallacy

• “I might as well keep eating because I already bought the food.”

Opportunity Costs: University, a not completely serious example

Opportunity Costs: University, a more serious example

Continue working vs. getting an MBA

Identifying Relevant Costs is Context-Specific

What’s relevant and what’s not differs across decision problems

‒ One time order / special pricing

‒ Outsourcing (make or buy) decisions

‒ Product-mix with capacity constraint(s)

Relevant information in a firm context

Excess capacity or not?

One-time special order

Normal sale Special order sale

Should Mountain Goat accept the offer?

Extreme Outsourcing at Volkswagen Resende, Brazil

Relevant Costs for Outsourcing Decisions

Make Shifters Buy Shifters

Which costs are relevant? 122,000 152,000

Accept the offer?

Relevant Costs for Outsourcing Decisions

What if the capacity that we free up through outsourcing can be used to

Make Shifters Buy Shifters

Which costs are relevant? 182,000 152,000

Relevant Information for Outsourcing Decisions

• Which costs differ between insourcing and outsourcing options?

• Other considerations in outsourcing decisions

Source: Financial Times RSM – 2019-20 15

Product Mix Decisions with Capacity Constraints

Source: Financial Times RSM – 2019-20 16

Product Mix Decisions with Capacity Constraint

Product Mix Decisions with Capacity Constraint

‒ Once demand for that product is satisfied, produce as many units as

Product Mix Decisions with Capacity Constraint

• Contribution Margin per unit of constrained resource (machine hours)

• Total Contribution: 7,000 * $12 + 3,100 * $15 = $130,500

No/little differentiation among products

Firms determine costs to produce and sell product

 Full cost pricing

 Variable cost pricing

Full Cost Pricing: The Death Spiral

AEMO charged consumers

Network fixed costs

Fixed costs spread over

Source: TheConversation.com RSM – 2019-20

Firms determine costs to produce and sell the product

Full cost pricing

Variable cost pricing

Pricing Decisions Without Cost Considerations

Martin Shkreli - MSMB Capital Management

RSM – 2019-20 •25

Pricing Decisions Without Cost Considerations

• Valeant’s business model: Buy R&D intensive pharmaceutical companies, close